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Greece is on the way to default, sooner or later. Even Prime Minister George Papandreou's vow on Friday to step down and form a coalition government won't be able to stave it off.

The dam burst early last week, days before the government won a parliamentary vote of confidence on Friday.

First was the move by Greece's Prime Minister George Papandreou to put fiscal austerity -- a requirement for all financial support offered to Greece so far -- to a national referendum.

Second was an opinion issued by the International Swaps and Derivatives Association, which sanctions derivative financial products, that the 50% haircut demanded of Greece's creditors appears to be "voluntary." Voluntary haircuts would not be considered credit events and will not trigger credit-default swaps. In other words, banks and others who bought those instruments as protection for their holdings of Greek debt may be plumb out of luck.

Greece's creditors have always assumed they would be able to mitigate the cost of resolving Greece's predicament by passing the buck back to the Greek people. Rather than empower the Greeks to continue living as they have chosen to live -- enabled by greed cum generosity and easy credit -- the notion has been to compel penitent borrowers to adopt punitive lifestyle adjustments, minimizing the costs of stabilizing the crisis.

Papandreou's call for a referendum, which threw those assumptions into doubt, turned out to be a domestic political tactic to stave off the collapse of his government, and it was retracted.

Beware of Greeks bearing signs: If further austerity is rejected, creditors will bear the brunt.
Grigoris Siamidis/Reuters

The prime minister won a parliamentary vote of confidence late Friday, and then vowed to form a coalition government that would ratify a bailout package by Greece's creditors. But it could easily take weeks for the new government to become functional, and even then there would be no certainty on how it would act on the bailout. There simply isn't that kind of time.

The EU and IMF have already retracted eight billion euros ($11 billion) in loans meant to be disbursed to Greece later this month. Greece needs this money, urgently, to pay bills due in December. If the efforts to form a coalition government fails, Greece will run out of money. A hard and uncontrolled default will occur, regardless of the eventual political outcome. That promises cascading bank failures needing government-funded recapitalization.

THE POTENTIAL REPERCUSSIONS of the swaps ruling are also dire. The notion that any bondholder would voluntarily accept a 50% write-down of any asset is ridiculous by any rational standard.

Of course, you could say that the banks did this "willingly" because the alternative -- as presented to them by no lesser negotiators than the president of France and the chancellor of Germany -- would be a disorderly default on the debt.

As we understand it, ISDA's rules account for that contingency. If a write-down is agreed to by a creditor because the only alternative is a default, then that write-down is involuntary and constitutes a credit event. Now, however, the rules have been bent to fit the will of the politicians.

After this ruling, anyone who thinks their sovereign-bond holding is protected by a credit-default swap has to think again, because the CDS protection may turn out to be worthless. The risk profile of owning PIIGS debt (Portugal, Italy, Ireland, Greece and Spain) has just been elevated by a single stroke of ISDA's pen.

In finance, the first rule is that you have to pay a higher reward to get people to buy and hold assets that bear higher risk. ISDA has just trashed the market for all PIIGS bonds. Prices have to fall and yields have to rise to attract investors without insurance.

How far do yields have to rise to draw people into, say, the Italian bond market? Well, CDS pricing suggests a 400-basis-point premium for "insuring" 10-year bonds. So wouldn't the cost of uninsured Italian bonds have to rise by this same four percentage points if credible insurance could not be found?

Something positive has to happen to derail these scenarios, and there are only two ways to do that: Rehabilitate the borrower, or reinforce the lenders. If the borrower rejects rehab, then the imperative is to support the banking system with a capitalization scheme that is funded and nimble.

WHAT THE 17 GOVERNMENTS of the euro zone need to do is raise money, real money -- a lot of it -- and put that cash on the table as a backstop to any possible contingency. Guarantees and promises of funding are bogus. The EU summit concluded that "firepower" of €1 trillion will fix Euroland's problems, but Eurolanders do not want to raise that much cash. Promises are cheaper! Funding these promises by selling bonds or raising taxes will divert savings away from private investment, or decrease private consumption, or both.

Our base case is grim. If we read Greece's political mood correctly, a default seems more likely -- and imminent -- than ever. There are enough unprepared and undercapitalized banks in Europe to create systemic risk. Unless the governments act promptly to fund a credible bank-capitalization backstop, financial-system failure and depression lie in Euroland's near future.

CARL B. WEINBERG is chief economist of High Frequency Economics. This article is adapted from commentary he wrote for clients last week.